A Rite of Spring
In the spring of each leap year, we have a predictable—if tiresome—dog-and-pony show: the candidates for President of the United States denounce the newest gasoline price increases. We lived through this political purgatory four years ago, and it looks as though we will experience it again.
Recently, the soon-to-be Democratic nominee for president, John Kerry, used a California gas station as his backdrop to accuse the Bush Administration of creating the conditions that have caused the current surge in prices. While this article will show that government—including the current occupants of 1600 Pennsylvania Avenue—is the main culprit, the reasons that Kerry gives for the present situation do not square with the facts.
As we have dealt with this issue many times on this page, it is not necessary to again present the simple facts of supply and demand in the oil industry. However, being that the politicians are first in line to "address" this issue, I believe that it would be instructive to list a few myths of this current "crisis" (or whatever the political classes and their media lapdogs are calling it these days).
Myth # 1: Gasoline prices are at record levels
Most of my principles of economics undergrads correctly answered a question based on this myth, which demonstrates that at least some college sophomores are more adept at economic thinking than most journalists. Yes, gasoline prices are approaching nominal record highs, but since prices are denominated in money, the figures are meaningless without some comparison to the past.
I remember filling my old pickup truck with leaded gasoline at $1.20 a gallon in 1982. If the U.S. Government's Consumer Price Index means anything (and it is far from being a "perfect" measurement of inflation, as it tends to understate the real rate), that gallon of gasoline in today's dollars would be priced at approximately $2.30. Given that the latest announced "average price" of unleaded regular is $1.77, it would seem that we have a long way to go before we hit a real record.
Myth # 2: Oil Companies are gouging consumers
This is an old standard, and it plays more than "I Can't Get No Satisfaction" plays on the "60s Oldies" radio stations. However, like good disc jockeys, the politicians know how to bring out this old "hit" record. (Actually, I prefer the challenged tonality of Mick Jagger anytime to the screeching of the political classes.)
Keep in mind that gasoline prices have a tendency to go both up and down, depending upon the economic circumstances. Given the very competitive nature of oil pricing (yes, this most likely is a surprise to someone like Paul Krugman, but then he really is not an economist), it is doubtful that a few oil executives are pulling strings and getting rich over this whole episode. Although politicians love to claim that oil executives are "manipulating" prices during crises, the historical record demonstrates otherwise.[i]
In the past two decades, as research has clearly shown, the profitability of oil companies has been below the average when compared with other firms in the Standard & Poors 500 Index. Thus, if oil companies owned the market power that the critics have claimed, then it would be difficult to understand why petroleum executives have permitted their companies to perform so poorly when their "power" could have dictated otherwise.
Myth # 3: OPEC is to blame
Actually, the current set of conditions is a godsend for the OPEC nations, as their vaunted "market power" also seems to have taken a hit over the last 20 years. When we last left Saudi Arabia in 1980, the country was swimming in petrodollars, and the citizens there were swimming in a bloated welfare state. The latest price hikes have permitted Saudi Arabia and some other oil-producing governments to run budget surpluses, something that has been almost as rare in that part of the world as balanced budgets have been with the U.S. Government.
Again, if OPEC had the market power that media commentators and the political classes have claimed, then one also would have expected the world's largest single oil producer, Saudi Arabia, to have better fortune with its own finances. Now, there is no doubt that the current OPEC cutbacks in oil production have had an effect upon oil prices; that is a no-brainer.
This situation, however, leads to a more important question: Does OPEC create the market conditions, or is it reacting to them? If the former were true, then oil prices would not have declined as much as they have since the OPEC heyday of the late 1970s. Oil in 1980 sold for about $40 a barrel. In today's dollars, that would be approximately $90. Given that the highest recent price per barrel has been about $38, one can argue that in real terms, oil producers are receiving less than half of what they obtained in 1980. This certainly challenges any notion that OPEC "controls" the crude oil market.
Since the former proposition is questionable at best, it makes more sense to assume that OPEC is responding to current market conditions. Thus, we arrive at the obvious question: What kind of market conditions permit oil suppliers to hold back on producing crude oil—and profit from such activities?
The world's largest single market for gasoline is the United States, so that should be the first place where we look for answers. Not surprisingly, the more we search, the more we are likely to find the fingerprints of the political classes and their allies.
In his denunciation of the Bush Administration for the current price hikes, Kerry has claimed that there must be a dark conspiracy that is afoot, since both Bush and Vice President Richard Cheney have had business ties with the oil industry. Yet, since Kerry has not pointed out the causal mechanisms for the price increases, or at least has not adequately pointed out how the oil industry has managed to create such market conditions, one can dismiss his words as more political hot air.
However, that does not let the president and vice president off the hook. Surely, one of the pieces of the current oil market puzzle has been the war and occupation of Iraq. No doubt, Bush and Cheney and others in the administration believed that by now, oil would be flowing out of Iraq and flooding the market. Keep in mind that it has been the intention all along of making Iraqis pay for the American occupation through oil sales, but attacks on oil installations and pipelines in Iraq have severely disrupted oil supplies. To top it off, there is the problem of socialist ownership and price controls, neither of which the US will dismantle.
The political unrest in Venezuela also has contributed to the current market situation, especially since Venezuela is one of the largest single suppliers of oil to the United States. The president of that country, Hugo Chavez, openly has stated that he wishes to become a "Castro with oil." (No doubt, it is better to be Castro with oil than Castro with sugar.)
Although Chavez has the potential to wreak havoc by using oil money to finance communist insurgents throughout Latin America, one has to wonder what the U.S. role in the current problems of that country has been. While Bush and the C.I.A. have denied playing any role in the political instability of Venezuela, it would be a first if the C.I.A. were not involved, given that agency's history in Latin America.
That brings us to domestic oil policy, and it is there that we find one of the root causes for the recent gasoline woes. In 1981, the Reagan Administration lifted price and allocation controls from oil and gasoline, and the price of both fell in both real and nominal terms for more than a decade. There can be no doubt that the former led to the latter.
However, in 1990, the Clean Air Act Amendments required gasoline additives that ostensibly would result in "cleaner burning" fuels during the warmer months. These requirements kicked in during the spring of 2000. Furthermore, the rules are different for different localities, urban areas requiring more additives (such as MTBE and ethanol, which both cause environmental and financial dislocations by themselves) than less-populated places. (For example, between Chicago and St. Louis, there are more than 50 different mixtures required for gasoline sold in specific areas.)
Such requirements create two problems. First, they place tremendous pressure on refineries, which operate at near-peak capacity, especially during the warmer months when people are driving more often. Second, they prevent the price-smoothing arbitrages that occur when gasoline prices are sharply higher in one locality than a nearby place.
Not surprisingly, prices are highest in the urban areas with the strictest environmental requirements, with cities like Los Angeles, California, leading the way. For example, gasoline prices in semi-rural western Maryland, where I live, are at most $1.75 per gallon, which is considerably less expensive than what people in southern California pay for unleaded regular. That is why John Kerry opted for a photo-op in San Diego rather than my backyard.
Although one is relieved that Kerry did not call for re-establishment of price controls or demand yet another anti-trust investigation against oil companies like some of his competitors for the Democratic nomination, he did trot out the usual policy failures and part of what he called his "energy plan." His "plan" was as follows:
- Put political pressure on OPEC governments to produce more crude oil.
- Stop diverting crude oil to the U.S. Strategic Petroleum Reserve and use it for the general market instead.
- Raise fuel economy standards for automobiles manufactured for sale in the USA, (this is a favorite of the New York Times' editorial page).
- Continue to prohibit oil drilling on government lands in Alaska and elsewhere, including offshore areas.
None of these measures is a "solution," and will only make our markets even more vulnerable to wild price swings. (The only near-sensible proposal was the one on the Strategic Petroleum Reserve, which should not be in existence, anyway, but one doubts that Kerry would be willing to do away with that government boondoggle.)
As long as the political, legal, and environmental conditions in this country undermine stable and sound markets for oil and gasoline, we can expect the kinds of problems we currently are having. Jawboning the OPEC nations will only make people in those countries resent us more than they do already—if that is possible—and forcing up fuel economy standards come with its own set of costs (the Kerry and others conveniently ignore, like safety issues).
If the political classes and their allies would permit even semi-normal conditions to exist in the U.S. oil markets, perhaps people running for president would not look for photo-ops by gas pumps—unless to claim credit for the lowering of prices that surely would follow a return to sane markets. However, permitting normal markets to exist in oil and gasoline also would expose the truth, that being that government is the culprit here, not the solution. No doubt, the political classes would not want that truth to seep out, especially in a presidential election year.